Russell 2000: historical drawdowns point to more downside risk

2022年7月26日

The Russell 2000's drawdown from its peak has been important (-26%), but not as severe as those seen during the dot-com bubble in 2002, the 2008 financial crisis, and Covid-19 at the start of 2020, when the US small-cap index plummeted by more than 40%.

To reverse the current downtrend of the Russell 2000, the underlying causes must also be reversed, which are primarily rising inflation and the need to raise interest rates.

US ECONOMY: MACRO OVERVIEW

Inflation is now widespread and is not solely due to increases in energy prices, such as oil and natural gas. The United States still has a very tight labour market that requires a rebalancing of supply and demand, to avoid further wage pressures. There are currently nearly two job openings for every unemployed American (JTSJOL/UNEMPLOY) and the labor-force participation rate has not recovered to pre-Covid levels. The result is a strong pressure on salary growth, which is currently at 11% year-on-year.

The combination of higher energy prices and wage pressures raises labour input costs for US firms. Those who are unable to pass on higher costs to their customers will see their profit margins dwindle dangerously. In addition, since the Fed is firmly committed to raising interest rates, higher borrowing costs represent an additional drag on the growth outlook of small-cap firms.

RUSSELL 2000 index: outlook

The market believes that a recession will cause the Federal Reserve to slow its rate hikes or even reverse its policy stance. However, the Fed's focus remains solely on inflation, as the labour market remains close to full employment. To rebalance the labour market, the Fed will continue to raise interest rates aggressively.
The short/medium term outlook on the Russell 2000 index remains bearish until the Fed signals a change, which is unlikely unless there is a major recession.

A 40% drop from the peak would be a good entry point for opportunistic buyers to step in, indicating a wide bullish positioning clean-up. Such a level of drawdown corresponds to a Russell 2000 index level of 1,450.